12 Signs and 158 Reasons Investors Should Avoid Chinese RTO Stocks

In an article titled "Beware this Chinese Export" featured in this week's Barron's magazine, author Leslie Norton analyzed 158 Chinese companies that obtained their U.S. share listing via reverse merger and discovered that the median company’s share price underperformed the Halter USX CHINA Index by an astonishing 75% in the first three years of trading, resulting in large losses for investors in these companies.

The USX CHINA index itself is down 15% in the three years ending August 27, 2010.Losses to reverse merger investors are truly staggering, begging the question why anyone invests in them at all. Fortunately, Leslie goes into great detail explaining all the problems with these investments. Her analysis is in fact very similar to my own.

I have found that there are at least 12 predictive factors associated with the poor share price performance:

Unscrupulous stock promoters behind the reverse mergers

Revenue disappointments and earnings restatements

Drastic divergence between financials filed with the U.S. SEC and Chinese regulators

Huge cash and shares fees paid to middlemen

Huge dilutive warrant shares granted to Preferred investors such as Pinnacle and Barron

Auditors such as Kabani and Frazer Furth with very poor track records

Complete inability of the SEC to oversee firms with foreign operations

Lack of any oversight of the U.S. listings by Chinese regulators

Lack of due diligence by investors and bankers who often subsequently find the Chinese operations don’t measure up to descriptions in placement offerings

Management theft and misuse of proceeds from share issuances

Complete inability of U.S. investors to recoup losses from unscrupulous companies and promoters under U.S. and Chinese law.

Lack of any effective corporate governance

Among many companies mentioned in the article, recent notably poor performers include OTC:CHNG, OTC:FEED, ONP, and OTC:RINO.The riskiest stock featured in considerable detail in the article is China Green Agriculture (NYSE: CGA).CGA’s investors suffer from nearly all of the 12 poor share price performance predictive factors mentioned above.Additionally, as I mentioned last week, CGA is the subject of an extremely negative and incredibly detailed due diligence report just released for clients of the International Financial Research & Analysis Group (IFRA).The report exhaustively documents in over 100 pages that:

Almost $15M VAT tax accrued by CGA over the past two years was never paid to the chinese tax authority, which collected only about $68k cash. Moreover, why did CGA accrue so much VAT when the law says they are exempt? This discrepancy exposes a $15M hole in the balance sheet.

$2.8M corporate income tax CGA says it paid in calendar year 2009 was likewise never received and recorded by the government authority. "Where did the money go?" the report asks.

$10.7M CGA reported it paid for greenhouse land last September was overstated by 4X. Multiple official documents show only $2.5M paid resulting in another big hole in the balance sheet.

For calendar year 2007 and 2008, SEC filings show Jinong sales of $14.8M and $22.9M, but government records show only $6.6M and $7.8M. Chairman Li personally signed off on both records.Chinese and U.S. accounting rules are slightly different, but the discrepancy here is huge.

For calendar year 2007 and 2008, SEC filings show Jinong net income of $7M and $9.7M, but government records show only $1.1M and $1.3M. Once again Chairman Li personally signed both records.

CGA's U.S. auditor Kabani & Company has only one other sizable client in China ((NASDAQ:LLEN)); unfortunately Kabani used to audit Bodisen Biotech, which strangely enough is based in the same high tech park as CGA in Xian. Bodisen was a huge scandal.Kabani therefore can’t be trusted to do good work.

IFRA shows that the Beijing Gufeng acquisition price tag is outrageous. They calculate the total cost could be $48M USD, pointing out that in addition to the $33M cash+equity purchase price there is another $14.7M in working capital that CGA is required to contribute to keep Gufeng afloat. Incredibly, according to Chinese government filings Gufeng lost money in 2009 and only turned a small profit in prior years.The acquisition price is insane.Where is the price paid really going?

Note: Scanned copies of the key sections of the IFRA report can be downloaded in several pieces here.

Conclusion: Leslie Norton did the best job to date detailing the serious problems with Chinese to U.S. reverse merger companies.The solution is not more regulation, but simply for investors to do their homework and steer clear of companies that exhibit more than a couple of the predictive factors associated with poor share price performance.In fact, if investors don’t invest, the companies, promoters and bankers will have to clean up their acts to attract capital.No regulator holds more power than the power of investors who refuse to invest.

Perhaps this article, combined with low investor attendance at Roth Capital’s China stock conference this week in Maui and continued declines in stocks like CGA, will be enough to spur real change.I wrote a summary of the change needed on my blog on August 22.

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